Business Laws

Converting equity shares into preference shares

| | Updated on: Nov 28, 2021
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Preference shares carry preferential rights on the matters of payment of dividend and repayment of capital – a privilege that the equity shareholders don’t have

Paving the way for corporates to give structured exit to their shareholders, the Mumbai Bench of the National Company Law Tribunal has recently sanctioned a scheme of amalgamation that involves the conversion of equity shares into preference shares. The Tribunal felt that the conversion of equity shares to preference shares could not be deemed to be impermissible, as opined by the Registrar of Companies (ROC).

Preference shares carry preferential rights on the matters of payment of dividend and repayment of capital – a privilege that the equity shareholders don’t have. In the instant case, the shareholders of the transferee company, holding a portion of equity shares, had requested regular dividends/ redemption of their investment as they were not interested in seeking control and management of the company. The transferee company expressed its inability to pass on such a benefit and consequently proposed to convert the equity shares into 9 per cent non-cumulative optionally convertible preference shares.

The ROC objected, saying that the equity to preference swap is not permissible as per law. The company, however, contended that the conversion was not barred by the legal framework and in fact, such conversion amounts to ‘re-organisation of share capital’ permissible as per Companies Act in case of ‘compromise or arrangement’ of a company with its creditors and members.

To substantiate its claim, the company relied on the verdict of the Apex Court, wherein it was held that ‘every procedure is to be understood as permissible till it is shown to be prohibited by the law’. The company stressed that the very purpose of the scheme of reconstruction is to make available alterations in the structure of a company to enable it to function. A scheme, therefore, which contains ultra vires provisions to Memorandum of Association (such as alteration of rights of shareholders) can also be sanctioned.

Tribunal’s acceptance

The Tribunal accepted the claims of the company and concluded that when shares of one class are converted to another, the value of paid-up share capital does not undergo any change. Plain re-classification of equity shares to preference shares and vice versa, has the effect of mere alternation of nomenclature of shares, without impacting the subscribed and paid-up share capital. It acknowledged that the prevailing law does not proscribe such a conversion.

Notably, to protect the interests of dissenting minority shareholders, the Tribunal said that any interested person (including a minority shareholder) could apply to the Tribunal regarding this matter for any directions that may be necessary. Further, the Tribunal accepted the stance of the assessee, based on the pronouncement of the Division Bench of the Punjab and Haryana High Court, that the term ‘arrangement’ is of wide amplitude and that a Scheme requires adherence to various legal provisions and enactments.

The legislature, therefore, deliberately does not restrict the scope of the term ‘arrangement’ by defining it. In fact, explanation to Section 230 of the Companies Act permits, by way of an inclusive definition, that an ‘arrangement’ may be in the form of reorganisation of share capital. Since the scope is not restricted, it would be against legislative intent to fetter the activities of a company and restrict the choice of the members or creditors or stakeholders.

The ruling will facilitate a flexible corporate restructuring for private companies and family settlements. Minority shareholders, not interested in the control and administration of a company, will be able to secure a comfortable exit. The approval of the scheme permitting conversion would also help indebted companies, facing difficulties in paying-off debts taken from holding companies. In fact, the share conversion route will also enable settlement with creditors, who hold equity shares of the company.

The flexibility shown by the NCLT is laudable because, while staying within the ambit of law and supporting judicial pronouncements, it has clarified that a scheme of compromise or arrangement may involve increase, consolidation, sub-division of shares or reduction of share-capital; likewise, conversion of equity shares to preference cannot be disapproved.

The author is Partner at Nangia Andersen LLP, a law firm

Published on November 28, 2021

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